Investing: Options

Some Random, But Perhaps Useful Thoughts

It’s always interesting to have stock conversations (hey, at least for me). It tells me a lot about the mood of the individual investor. And then, if you watch the news and read the trades, comparing what the individual, the media, and the professional investors are saying becomes even more interesting.

The professional traders are always looking for the next opportunity. But the average man or woman on the street has fallen silent. Last summer, when the market was booming, everyone wanted to talk about stocks. Now, it’s just, well… kinda there.

And that in itself should tell you something. This is actually the time the retail investor should be looking for opportunities. Here’s a simple piece of evidence: Buffett has been buying, and he buys bargains. That alone should pique your interest.

We’re still being haunted by the credit crisis. But the freefall, the chance that a bank or an investment bank would go under and take the financial system with it, has faded. That, all thanks to the Fed and its “bailout” of Bear Stearns. So the buildings are still standing, but they’re not yet fixed. Now comes the cost cutting, the layoffs, and the sales of non-core or unprofitable businesses. Make no mistake, profits of financial companies will be down – “ all those clever ways of making money have disappeared. And the downward earnings revisions are ongoing.

The question is, how is this affecting stock prices? Citigroup reached a recent high of just over $26. Since then, it’s fallen to about $22.17 today, May 20. That’s because the market knows there are still lots of problems to be solved. Will it go down more? It might, and in fact, it probably will. But I do think we are in range to be shopping. Like the rest of the financials, I don’t think Citigroup is fixed, but it won’t fall off a cliff either.

The other pressing areas these days are oil, commodities and inflation.

Let me start by saying that I don’t care what the statistics say, inflation is here. First, it’s inevitable given all the liquidity that’s been put into the market. For those of you not familiar with the mechanics of inflation, think of it this way; If the Fed lowers interest rates, making more money available, the consumer spends more. And prices go up to match the consumer’s new spending level. That’s pretty much it in a nutshell.

a word of caution: if you choose to play oil (or any commodity, for that matter), be ready to move fast and get out if you think the tide is turning.

Ming Lo

Second, the prices of many commodities, and especially oil, are denominated in dollars. So that’s really going to amplify the effect and increase domestic inflation.

Are we in a bubble? OPEC is saying that it’s producing to meet demand. In other words, they’re arguing that prices are higher than they would be if it were simply a matter of demand and supply. That implies a bubble, or at the very least, speculation as a driver of cost. On the other hand, T. Boone Pickens, the famed oil investor, said today that it’s simply a matter of supply and demand. He says that supply is at 85 million barrels a day, and that demand is 87 million a day. Pickens believes in $150 oil by the end of the year – “ and remember, a little while back, he called $100 oil. Finally, today, testimony on capital hill before Congress was that speculators are causing the spike in oil prices.

Confusing, isn’t it? Does it remind you of the real estate in 2005? Back then, prices were going up. There was definitely speculation and flippers were making money hand over fist. But there was demand too, because lower interest rates and adjustable rate mortgages brought more people into the market. So back then, you had both – “ higher demand and speculation driving up prices.

It stands to reason then, that we could have both factors today in oil. There’s definitely demand as the developing nations industrialize. But there’s speculation too, as financial investors buy more oil in anticipation of higher oil prices.

The real question is, how long will prices keep going up? And how do you trade, or benefit from the trend?

Unfortunately, I don’t have a great answer for you (my only defense is that I don’t think anyone really has a definitive answer). For the short to medium term, I think prices will continue to rise. And I say that only because I don’t know what catalyst will bring prices down. I can think of one factor – “ interest rates – “ that could turn oil. If you go back to oil crisis, the solution was sustained, high interest rates.

But that might not be the only factor in today’s markets. So that just leaves me with a word of caution: if you choose to play oil (or any commodity, for that matter), be ready to move fast and get out if you think the tide is turning.

While we are here, it’s worth looking at the impact of interest rates on commodities prices. And here, understanding the real estate boom is very instructive, I think. Back in 2004-2005, a major driver of the real estate boom was the difference in interest rates among countries. As an example, take the yen carry trade. Hedge funds and speculators were borrowing at low rates in Japan and using it to invest in higher yielding securities here in the States. The funds further enhanced their profits by leveraging, some say 20x-30x, some reportedly as much as 40x. This supported the market for all those fancy CDOs, SIVs and other financial instruments that got us into the trouble we’re in now. And those instruments supported the real estate market.

I suspect that today, we have a similar situation. The US lowered rates to deal with the credit crisis, but other countries have not followed and lowered rates as much as we have. That’s because they’re afraid of fueling inflation. The European Central Bank is holding rates steady, creating a differential between US and European rates. So is the Bank of England. Some traders are short the pound because they believe that the Bank of England will eventually have to lower rates. I’m sure there are traders that are short the Euro.

Lowering interest rates is inflationary and drives up the price of oil. And remember, oil is denominated in dollars so lower US rates have the biggest effect. The difference in US versus foreign interest rates exacerbates the problem because it drives up the price of oil in dollar terms faster than in other currencies. I don’t know when the price of oil will roll over, but an increase in US interest rates would definitely contribute to a correction. Already there is talk of raising US interest rates in the fall to counter inflationary tendencies in the economy.

Citigroup Options: LEAPS and Call Spreads

I don’t really do a lot with options, I should tell you that. One reason is that options place an additional constraint on your investment: time. If you buy a stock and it doesn’t hit your target price within a year, it might still do that in year 2. Buffett avoids options, or so he says, because he admits he doesn’t know exactly when an event will occur.

Think of it another way. One way of investing in stocks is to eliminate risks, or to have the biggest margin of safety possible. By putting a time limit on your investment, you can increase risk – “ unless you know how to use options properly. So word to the wise: the following is for advanced investors only. Besides, the math alone will make your eyes roll unless you really, really like this stuff. Or wanna make some dough.

Let’s get back to Citigroup. In a previous article, I quoted someone that said it was time to buy Citigroup when three conditions were fulfilled:

When the price to book ratio is close to 1

When the dividend has been cut

When there’s bad news and the stock doesn’t go down

Today, the price to book ratio stands at 1.12; the dividend has been cut; and the stock has declined, but doesn’t always have a knee-jerk drop when there’s bad news. So I think we’re in the window, and I’ve started to build a position in Citigroup. Mind you, not all the marbles, but I’ve put a little bit of money into it, and am waiting to see how things develop before putting more in.

So one way to invest in Citigroup is simply to buy and hold. If you accept the argument that this is (among) the worst of times, and that in a few years, the stock will be (among, or at least closer to) the best of times, then you can start to build a position as I have.

Still, I couldn’t help noticing that there is an opportunity in Citigroup LEAPs. And what are LEAPs? LEAPs are Long-Term Equity Anticipation Securities… and that of course didn’t help at all. In lay terms that I understand, LEAPs are options with expiration dates that are longer than one year. Now wasn’t that much simpler? Who makes up these names anyway?

So why is there an opportunity? Because the cost of options is low when expectations are low or when volatility is low.

Traders that are bullish often execute a call spread. That means selling a higher price call and using the proceeds to buy a lower price call. The best way to understand this is to go through an example.

Ming Lo

So let’s look at some basic options pricing attributes. First, you pay a premium for the long-term aspect of a LEAP, that’s obvious. Consider this: today, Citigroup is at about $22.11. If you buy the June 08 $22.50 calls (a call is the option to buy), that will cost you $0.80. Meaning, it would cost you $0.80 for the right to buy Citigroup stock at $22.50 any time up until expiration in January 2010. The Jan 10 (January 2010) $22.50 calls are $4.35, so you’re paying $3.55 more to have the option of buying for an additional year and a half.

That might sound like a lot, but compare the Citigroup Jan 10 calls to the Apple Jan 10 calls. Apple trades today at $185.90, and Jan 10 $190 calls cost $44.55. So that’s $44.58 for the Apple options, $3.55 for the Citigroup options (these aren’t exactly the same options, but the most similar). So why the vast difference in price? For the most part, low expectations for Citigroup, high expectations for Apple.

Let’s look at this another way. Let’s compare the upside vs. the downside of the Citigroup options. If you’re going to exercise the option, the stock has to rise to $22.50 + $4.35, or $26.85, for you to breakeven. So anywhere above this price you’re in good shape. The interesting part is that it doesn’t have to be far beyond $26.85 to deliver you a good return. To get a 25% return on your $4.35 investment, you need $4.35 x .25, or $1.09 above your breakeven. So if you believe that Citigroup can reach $26.85 + $1.09, or $27.94 by January 2010, then you’ve got a very good chance of earning 25% on your investment. And if the stock reaches $27.94 before January 2010, then you have your gain plus the remaining time value of the option.

But there’s another way to make money. Let’s say the stock reaches $23.50 in three months. What’s the value of the Jan 10 $22.50 call that you purchased for $4.35 today? We can break it down into two parts. If you estimated the value of your $4.35 investment in a January 2010 call by pro-rating it over the remaining time, then the call would be worth $3.63 in three months (this is not the “right” way to do it, but it’s an estimation for the purposes of this article). Since the stock is now $23.50 instead of today’s $22.11 price, you can add $23.50 – $22.11 = $1.39 to your $3.63. That gets you to $5.02. That means you can sell your call for an estimated $5.02, and earn $0.67, or 15%. That’s not bad at all. The only caveat is that Citigroup still has issues, so the stock will fluctuate over the next several months. But I do think that there is a good chance that the value of your LEAP will increase significantly sometime before expiration in January 2010.

Alright, that was a lot, wasn’t it? And a lot of math. Well, I’ve got one more for you if you can bear it.

Traders that are bullish often execute a call spread. That means selling a higher price call and using the proceeds to buy a lower price call. The best way to understand this is to go through an example.

If you were to look up Citigroup calls today, you would find the following:

Expiration

Strike

Cost

Jan 10 Call

$22.50

$4.35

Jan 10 Call

$25.00

$3.35

Just a quick fyi. When you trade options, you buy contracts, and each contract covers 100 shares. So if you buy the January 2010 $22.50 call, you would buy 100 of them and the total cost would be $435. For the simplicity, we’ll deal with the $4.35 number, but keep in mind that if you choose to execute this transaction, you’re dealing in lots of one hundred.

So a bull spread might be constructed by selling the January 2010 $25.00 call and buying the January 2010 $22.50 call.

Selling the January 2010 $25.00 call gives the buyer the right to buy Citigroup shares from you at $25.00. For that option, you receive $3.35. You can take that money and use it to help finance the purchase of the January 2010 call for $4.35. So your net cost is $4.35 – $3.35, or $1.00.

So if the stock falls to under $22.50, your buyer would not execute his call, nor would you execute yours, and your loss would be $1.00.

If the stock rises to above $25.00, your buyer could execute his call, buying the stock for $25. In turn, you could execute your call, buying the stock for $22.50. Your gain would be $25.00 – $22.50 = $2.50. Given that your investment was $1.00, your return is 150%. Hey, that’s pretty good! And I think there’s a very high likelihood that the stock will be above $25.00 by January 2010.

Still, let’s see what happens if the stock is $23.50 at expiration. In this case, your buyer would not execute his option. But you could execute yours and buy at $22.50. At $23.50, your gain is $23.50 – $22.50, or $1.00. Given a cost of $1.00, you break even. So if the stock is anywhere from $23.50, you are net positive.

I think there are some really interesting possibilities for profit here. Take a look, investigate, and decide for yourself.

Until the next time, sleep well.

Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.

All material presented herein is believed to be accurate but we cannot attest to its accuracy. The writings above represent the opinions of the author, and all readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed may change without prior notice. The author may or may not have investments in the stocks or sectors mentioned.